This is a guest post by Joseph Y. Calhoun at Alhambra Investment Partners.
His post starts off with this quote by Stanley Fischer, Fed Vice-Chair in a
speech before the National Association for Business Economics.
Says Fischer “We may well at present be seeing the first stirrings of
an increase in the inflation rate — something that we would like to happen.”
I dispense blockquotes using a guest post format.
Is Inflation About To Make A Comeback? by Joseph Y.
Calhoun
Anyone renting an apartment over the last few years might well wonder what
rock Mr. Fischer has been residing beneath – and whether it was rent
controlled. Certainly not all prices have been as reluctant to rise as the
CPI itself which has been running quite a bit beneath the Fed’s target the
last few years. But relative price changes, where the price of one good or
service rises as another falls are not inflation by any definition. And so
despite the rapid increase in rents the even more dramatic drop in the price
of oil and other commodities means that the CPI and the other measures of
official inflation have not risen as fast as our monetary minders would like.
They would like us to be impoverished at a more rapid clip apparently. I’ve
never really understood the economic profession’s fear of deflation. It is,
after all, the very evidence that capitalism is all it’s cracked up
to be. Improving productivity, the very definition of economic growth, is
deflationary.
In any case, when I speak of inflation I don’t really care much about the
CPI or the other government sponsored price measures. Price indexes are
nothing more than attempts – inevitably flawed – at measuring the value of
the currency, the US dollar in the case of America. What the CPI or the GDP
deflator or the PCE deflator attempt to measure is the purchasing power of
the dollar. I prefer to observe the value of the dollar more directly.
The various dollar indexes provide us with information about the dollar’s
value versus other currencies. Gold provides an indication of the value of
the dollar as do general commodity indexes. So when I ask if inflation is
about to make a comeback, what I’m really wondering is if the value of the dollar
is about to fall. I prefer these measures not because they are more accurate
– although I think they generally are – but because they are more timely.
Prices will follow the value of the dollar eventually but the impact on
investments is much quicker.
The movements of the dollar can have a dramatic impact. Just witness the
incredible changes in the energy industry over the last two years as oil
prices collapsed. The explanations for that collapse are myriad and some of
them conspiratorial but there seems little doubt the dollar played a major
role. It is not mere coincidence that the dollar started to rise strongly and
oil started to fall at the same time in mid-2014. I suppose one might argue
about causation – the fall in oil prices may have caused the rise in the
dollar – but that the two were linked seems beyond question. It might be that
causation ran both ways but frankly I’m not sure it matters; the dollar value
will impact the price of oil and other commodities. There may be other
supply/demand fundamentals having an impact on individual commodities but
when they rise or fall together, the culprit is always the dollar. And in
this case it wasn’t just oil that was falling.
The rise of the dollar and the fall in commodity prices over the last two
years has had a dramatic impact on the global economy and markets. South
America is in the midst of one of its periodic bouts of stagflation as
capital flees and currencies collapse (Chile as usual an exception). Japan’s
devaluation – the flip side of the dollar rise – produced rapidly rising Yen
profits for Japanese corporations and a bull market in stocks even if the
economic results left a lot to be desired. That’s probably because the rest
of Asia felt obliged to let their currencies fall against the dollar as well.
The fall off in emerging market growth, a function of capital outflows and
lower commodity prices, offset any advantage Europe gained by going first in
the global currency war, the Euro falling from 150 to 125 before the Yen even
peaked in early 2012.
The stronger dollar also had an impact right here at home as lower oil
prices pressured the energy industry. The collapse in oil prices and the
deterioration in shale companies’ balance sheets pushed credit spreads wider
as investors fled the junk bond market. That has had an impact on all lower
rated companies trying to get financing in that market and has likely had an
impact on growth at the margin. GDP growth has been weaker than expected, the
long awaited acceleration deferred again. Capital spending has remained
subdued, consumption has grown only slowly as inventories built and
individuals opted for more saving. Manufacturing is in recession and profits
are down for three straight quarters. In short, the US economy has been a big
disappointment.
It is in that now reduced growth outlook that one must look for clues
about the future course of the dollar. A brighter growth outlook played a
role in attracting capital to the US and driving up the value of the dollar.
As that growth outlook has dimmed so has demand for dollars and US
investments. The dollar index peaked a year ago and even emerging market
currencies have recently been rising against the greenback. The outlook for
Fed policy has moved in a dovish direction as rate hikes keep getting pushed
out. Global growth expectations are equalizing, something I started
anticipating a year ago, and as they do the relative strength of the
dollar wanes.
It is frankly hard to see a reason for the US dollar to weaken
significantly. US growth may be disappointing but it is still positive and
better than most of the rest of the world. Interest rates here are at least
positive, something increasingly rare in our upside down world. And while the
Fed may be pushing out rate hikes they still seem intent on moving in that
direction. So, why would the dollar weaken here? Why would someone prefer Yen
or Euros or $A or $C right now, much less Brazilian Reals or Colombian Pesos?
It may be as simple as relative values – asset prices outside the US,
especially in emerging markets, are cheap. Maybe China’s economy isn’t in as
much trouble as everyone seems to believe. Or maybe they will go on another
fiscal borrowing and spending binge. Maybe Europe is ready for a cyclical
upturn even if negative rates and QE haven’t accomplished much. The arrest of
Lula may mean the Brazilian Petrobras scandal is nearing an end. Is the
political change in Argentina a harbinger of better political outcomes in
other parts of South America?
A fundamental explanation for renewed dollar weakness may come from closer
to home. The US economy is not performing well and bond markets are pointing
to continued weakness. Real interest rates have recently slipped into
negative territory. Credit spreads have improved over the last few weeks but
the trend is still negative. Earnings just logged their third straight
negative quarter and Q1 2016 looks to make it four. While a recession
probably shouldn’t be the base case for the US, it certainly can’t be ruled
out. We probably shouldn’t discount politics either in this election year.
The leading candidates – for now anyway – don’t inspire much confidence and
most of them seem intent on offending as many foreigners as possible. Not
exactly the way to encourage capital inflows that might bolster the dollar.
The markets are already moving toward a more inflationary future. The
dollar index peaked a year ago and has been trading in a roughly 8% range
since. Gold is up 20% since early December and gold stocks are up quite a lot
more. TIPs have suddenly found a bid after trailing the rest of the bond
market, up over 3% since mid-December. Copper is up 15%. Crude oil is up a
stunning 46% from its low. The SPDR Metals & Mining ETF is up 65% since
mid-January. The Materials ETF is up 16%. Even the general commodity ETF,
GSG, is up over 17% from its low. The move into weak dollar investments has
been rapid and probably reflects more short covering than real investment
buying but buying it is.
Inflation expectations, fears, are rising and markets are
responding. Markets are not infallible and it could be that these moves
are quickly reversed as the deflationary fears of the last few years return.
But I have my doubts. It has always seemed inevitable that the aggressive
monetary policies of the world’s central banks would end in inflation. We may
have finally reached the point where everyone looks askance at fiat
currencies, preferring to hold their capital in real assets rather than ones
that depend on confidence in economists and politicians. Considering the
track record of economists and their models and the current crop of
Presidential candidates the only wonder is that it has taken so long.
End Calhoun
I like many of Calhoun’s observations, especially this one:
“I’ve never really understood the economic profession’s fear of deflation.
It is, after all, the very evidence that capitalism is all it’s
cracked up to be. Improving productivity, the very definition of economic
growth, is deflationary.”
Bingo: Productivity improvements are inherently price deflationary.
Central banks are hell-bent on stopping a true benefit of capitalism.
Calhoun says the CPI is fatally flawed. I agree. In fact, all attempts to
measure inflation by measuring prices are flawed by individual preferences as
well as an impossibility to measure some prices precisely.
For those who own a home, rising prices does not seem inflationary. For
those who don’t own a home and want to buy one, price inflation is a huge problem.
And renters see things quite differently than homeowners.
Also, some prices are more nebulous than others, such as the price of a
home. And some people believe home prices should be in the CPI and others
don’t.
Direct Observation
Calhoun says “I prefer to observe the value of the dollar more
directly. … So when I ask if inflation is about to make a comeback,
what I’m really wondering is if the value of the dollar is about to fall.”
In effect, he is coming up with his own version of the CPI, measuring
things he believes ought to be in it.
I receive emails all the time regarding personal inflation measurements.
The number one complaint is health care. But those over 65, on Medicare,
don’t complain as much.
Direct observation will yield a different measure for each observer.
Someone in the Eurozone, looking at what a Euro buys, probably sees
deflation now. Then again, someone in Spain sees things differently than
someone in Greece or Germany.
Alternative Measures
I prefer to view inflation and deflation in terms of credit expansion and
contraction.
I picked credit expansion or contraction marked-to-market as that is what
will influence stock prices, bank lending, hiring, and a host of other
factors.
Others see things solely in terms of money supply expansion as measured by
“True Money Supply”.
But as long as one defines their measure, we can discuss it.
In light of my own definition, we have been in an inflationary period
since March of 2009 or so.
Gold, Crude, the Dollar
Crude is up 46% but gasoline prices are up half that. Gold is up 20% or
so, but is that in anyone’s price basket?
It’s important to be consistent. If we are to measure inflation by
observation of recent weakness in the dollar and the surge in the price
commodities like crude, gold, and copper, then we just came through one of
the most deflationary periods in history!
Did we just have a massive bout of deflation? If Calhoun is consistent in
his observations, apparently we did.
I am a deflationist and I don’t see it that way. However, I do expect
another deflationary credit bust based on declining asset prices.
Final Thoughts
Calhoun concludes “We may have finally reached the point where
everyone looks askance at fiat currencies, preferring to hold their capital
in real assets rather than ones that depend on confidence in economists and
politicians. Considering the track record of economists and their models and
the current crop of Presidential candidates the only wonder is that it has
taken so long.”
I sympathize, but it’s not quite that easy.
Take a look at housing. Prices are capped by what millennials can and will
pay. Oil is capped or at least slowed by China’s rebalancing. So are
base metals.
What about home prices in China, Australia, Canada, and the UK? Are we
about to witness a rush into those assets or did we already have that rush?
Some real asset prices are capped by debt and currently dependent on the
“greater fool”.
Are Interest rates headed to the moon?
I don’t think so. Those who do think interest rates are headed to the moon
and the dollar will collapse into oblivion need to explain negative rates in
Europe and five other countries, and the massive debt-to-GDP ratio of Japan.
What’s Left?
Guess what hard asset is left, one with no debt or associated liabilities?
Gold.
Mike “Mish” Shedlock
